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News & Media

Wednesday, February 24, 2016

Julian Howard, Investment Director, looks at the influence of political risks on financial markets and how investors should factor these risks into their investment strategy.

Politics can actively threaten the stability of markets, with elevated political uncertainty around the world in part explaining the weak start to 2016 for equities. Fundamentals have not deteriorated to such a significant degree to justify the magnitude of the market move. Nor is this theme likely to go away anytime soon, with the list of politically driven threats facing markets extensive. For investors, the challenge will be to mitigate some of these risks, while also assessing scope for opportunity.

Relationship with markets

Politics affecting markets makes intuitive sense, but quantifying the influence has always been challenging. Enter the Economic Policy Uncertainty Index. Over time, the US version of the index has demonstrated a close enough relationship to US equity market returns to suggest that political analysis should at least be part of the toolkit investors deploy when making portfolio decisions. While predicting specific political outcomes is notoriously difficult – think May 2015 UK election exit poll – a broader sense of when political uncertainty is elevated, along with the possible sources of that uncertainty, could give investors an edge.

January 2016 is a case in point. Market commentators and economists have studied fundamental factors in search of a cause for the month’s equity volatility, with former US Treasury Secretary Larry Summers declaring that the market moves are often an accurate leading indicator of economic malaise. But many have not considered political uncertainty as a factor in itself. The immediate eurozone crisis over Greece’s debt may be over but there are plenty of new sources of uncertainty facing investors in 2016.

Political uncertainty and markets: a persistent relationship even if not in lock-step

Source: Policyuncertainty.com, GAM; as at 1 Jun 1985 to 1 Dec 2015

Political uncertainty today

Recent oil price behaviour is rooted in geopolitical rivalry in the Middle East. While Saudi Arabia has sought to undercut US shale producers, a more potent factor could now be Iran. The country has an estimated five million barrels of oil ready for delivery to European refineries and is aiming to add half a million barrels of production capacity annually, more than last year’s cut in US production. Absent a significant leap in demand, this is likely to keep the oil price from recovering. And if its current high correlation to equities persists, market volatility could remain elevated as a result.

China’s policymaking, or the lack of clarity around it, represents another major source of uncertainty and played a key part in the sell-off in August 2015, as well as January 2016. Key decisions around currency depreciation, capital controls, monetary and fiscal policy are all highly politicised and unpredictable as the authorities seek to manage the slowing growth rate.

Nor are supposedly more stable Western economies immune. In the UK, a referendum on European Union membership awaits. ‘Brexit’ risk appears to have been a major contributor to downward pressure on sterling since last summer, and as the referendum approaches, other asset classes could be affected too. The US presidential race meanwhile could herald direct intervention in markets. This conclusion is easily reached when one considers the combination of existing disaffection with the role of markets in the public discourse and the increasingly populist tone of the recent debate.

What can investors do?

The challenge for investors is how to mitigate the risks, or even capitalise on them. Creativity and expediency will be paramount. Playing Middle Eastern geopolitics with the oil price or proxies, such as the Canadian dollar, is not for the faint-hearted, but keeping a close eye on the correlation between oil and equities is sensible. As long as the two continue to move together, expect equity exposures to be buffeted unpredictably by the politics of this region.

As for China, many hedge fund managers are publicly positioning in anticipation of a falling currency during the rest of the year. This implies they are seeing through the short-term politics on the assumption that depreciation is the inevitable policy choice. This remains a risky bet though, since hedge funds are particularly unpopular with governments, and Beijing has already warned them off direct speculative attacks against the renminbi. A better approach could be to go short the Japanese equity market during periods of currency depreciation, since it tends to suffer when the renminbi falls against the yen.

Turning to the UK, as the EU referendum approaches, positioning long volatility in cable or the UK equity market could work well. The bond market offers less scope for opportunity, unless a sizeable risk premium builds up in the Gilt yield.

As far as positioning for US political developments is concerned, there is scant evidence that markets have fared any worse under Democrat presidencies than Republican ones.

Political uncertainty has historically been an under-appreciated factor driving markets. This is partly because it has been hard to model due to its unpredictable nature and often binary outcomes. Few investors use it as a formalised risk factor in the same way that they would for momentum or value. But this is not to say that continuing to ignore it is appropriate, or that some attempt should not be made to account for political risk as part of a carefully considered investment process. In a volatile equity market environment, making sense of these risks could help preserve capital.

Nothing contained herein constitutes investment, legal, accounting or tax advice and should not be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. The statements and opinions are those of the author at the time of publication and may not reflect his/her views thereafter. Past performance is not indicative of future performance. No liability shall be accepted for the accuracy and completeness of the information.